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Tesla Has a Luxury Car Problem. Here’s Why Investors Should Be Worried

August 28, 2019, 3:00 PM UTC

On Wednesday, Tesla released third quarter delivery numbers. Those numbers showed continued overall growth for the electric car maker, but also continued a troubling trend. Sales of Tesla’s luxury Model S and Model X vehicles dropped to 17,400 in the third quarter, down from 17,650 in the second quarter, and from 26,903 in the third quarter of last year. That’s a 35% year over year decline.

The decline is particularly painful because the Model X and Model S, like most luxury cars, have particularly high profit margins. Tesla’s luxury vehicle profits dipped 57% in the first half of 2019 compared to the first half of 2018, thanks to both slowing sales and what Alliance Bernstein analyst Toni Sacconaghi called “a large de-facto price cut” on the S and X.

In August, Sacconaghi described “plummeting” profits from Tesla’s Model S sedans and Model X SUVs as “a huge drag” on the company’s overall financials. According to Sacconaghi, Tesla would have shown a profit in the second quarter of 2019, instead of a larger-than-expected loss, if S and X sales had held steady.

The continuing slide comes at a crucial moment for Tesla. The company’s growth strategy, laid out as long ago as 2006, has been to focus first on high-margin luxury cars, then use those profits to develop mass-market products. Sales of the Model 3, the first of those mass-market products, are rising faster than S and X sales are falling – but not fast enough to offset lost luxury profits.

The resulting decline in earnings is putting serious pressure on the company. It has faced growing skepticism in the bond market, and investors sent Tesla stock down sharply this week on the latest delivery numbers. So why are Tesla’s marquee models losing a step? And what could the company do to reverse the trend?

Competition

There are a few possible explanations for Tesla’s slumping luxury business.

In his August report, Sacconaghi argued that new luxury electric vehicles from the likes of Jaguar and Audi are cutting into sales of Tesla’s high-end Model S sedans and Model X SUVs. He focused on Europe, where the Audi E-Tron all-electric SUV and Jaguar I-Pace electric crossover SUV became available first. Sacconaghi concluded that, at least in Europe, the competitors have poached sales from Tesla.

But that displacement does not seem to be repeating itself elsewhere. The E-Tron and I-Pace have been on the market in the U.S. for less than a year, but early results have been disappointing. That’s particularly for the I-Pace, which has had a mixed critical reception. Jaguar is selling just 190 I-Paces per month in the U.S. That’s well below its European sales pace, and Tesla’s average U.S. sales of over 1,000 Model X units per month so far in 2019.

Things will only get harder for Tesla on the competition front, though, with high-end EVs coming from the likes of Mercedes-Benz and Porsche.

Cannibalization

Model S and X sales may also be declining because customers are choosing the less expensive Model 3 instead, with Tesla’s newer product ‘cannibalizing’ its existing offerings.

Sacconaghi’s August report argued that Model 3 sales were not cutting into Model S and X sales. But Matt Joyce, an independent Tesla analyst and investor who is broadly bullish on the company, does see cannibalization as a possible factor. The Model 3, he says, is actually a superior product to the S and X on several specific points.

The Model 3 uses more advanced batteries than those used in S and X. The Model 3 also has a driver-facing camera, which Joyce says will be useful for future autonomous operation. Similarly, the Model 3’s horizontal screen may be more appealing than the vertical screen currently in the higher-end models, especially after Tesla recently added streaming video to its vehicles. Perhaps most importantly, the more interior in the Model 3 is more modern than the Model S, including a dramatically reimagined climate control system.

Scott Mercer, who watches EV adoption closely as CEO of the EV charging startup Volta, agrees that Tesla’s own shifted focus has been hurting the S and X. With senior leadership suffering through Model 3 production hell over the last two years, there have been no major overhauls of the two luxury models. In fact, a previously announced revamp of the Model S was recently walked back by CEO Elon Musk.

Tesla constantly improves its cars’ design and software, and the Model S and Model X did recently receive a major drive-train update known as Raven. But that incremental approach might not be enough to maintain luxury buyer enthusiasm in particular. “The newness, or the feel of newness, can be very crucial,” says Mercer.

Joyce, while arguing that shunning model years makes Telsa more nimble, agrees that a major overhaul is needed for S and X.

“I’m hoping they refresh.”

The Pivot

While rejuvenated Model S and Model X sales could help Tesla’s bottom line in the short term, the future of the company is clearly the Model 3 – and soon, the similarly-priced Model Y crossover SUV.

“For a company to scale, they have to have a product that is $30-40,000,” says Gene Munster, a Tesla analyst with the venture capital firm Loup Ventures. “Without that, you’ll get a nice little business . . . but it’s not going to be mainstream.”

Munster believes Tesla can return to profitability as a mass-market carmaker within “maybe one or two years.” He points out that the Model 3 is already profitable in terms of parts and labor, and that a new factory in China will have lower overhead than the Fremont Gigafactory that currently produces all Model 3s.

Demand for the cars, at least, is pointing in the right direction. As of Sacconaghi’s August report, the mid-tier EV category that includes the Model 3 had exploded by 109% in a year. The question is whether Tesla can keep its dominant share of that growth, and do it profitably, before falling returns on its high-end models drown it in red ink.

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